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Calculating fair value of stocks

As an investor you have a required rate of return of 14 percent for investments in risky stocks. You have analyzed three risky firms and must decide which (if any) to purchase. Your information is

Firm A B C
Current Dividends $1.00 $3.00 $7.50
Expected Annual growth 7% 2% (-1%)
Current Market Price $23 $47 $60

a) What is the maximum price? Which (if any) should you buy?
b) If you bought stock A, what is your implied rate of return?
c) If your required rate of return were 10 percent, what should be the price necessary to induce you to buy Stock A?

Solution Preview

a) What is the maximum price? Which (if any) should you buy?

For Stock A
Current dividend=Do=$1.00
Growth rate =7%
Expected dividend next year=D1=Do*(1+g)=1*(1+7%)=$1.07
Required rate of return=r=14%
Fair Value of stock=D1/(r-g)=1.07/(14%-7%)=$15.28571
Market price of A is $23, which is higher than its fair value. I should not buy it.

For Stock ...

Solution Summary

Solution describes the steps to find out the fair value of given stocks. It also calculates implied rate of return for a desired stock.

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